Rise of the Machines: Examining the Future of Capital & Labor in Production

Mar 26, 2014 | L. Dwayne Barney

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Are we entering a Star Trek economy where nearly all of our desires are met by the simple push of a button? With 3-D printing, robots used in manufacturing, and program trading of stocks it seems we are moving that direction.

While 3-D printing is only in its infancy, the technology’s potential is stunning. The technology has been used to produce jewelry, guns, and medical devices. Moreover, robots and computers are now used to do repetitive tasks in manufacturing, to answer your calls when you telephone the bank, and to explore deep oceans and outer space.

Technological advances that allow for consumer goods to be produced more efficiently and at a lower cost have the potential to make our lives better. Robots, computers, tractors, and 3-D printers are what economists refer to as “capital,” and it is evident that capital is increasingly being substituted for labor in production.

When considering the ongoing substitution of capital for labor it is important to remember that the goal is not to have an economy that demands a lot of back breaking labor to obtain the necessities of clothing, food and housing. Difficult manual labor is a necessary hardship—necessary in order to obtain the goods and services that provide for an enjoyable life. And having machinery do the more grueling tasks is certainly a benefit.

Still, as machines do more and more of the work one wonders how the advancing technologies will impact the availability of jobs, the wages paid to workers, the future returns to be had from investing in capital, and the distribution of income.

How Economists Approach Labor & Capital

Historically, economists have opined that capital and labor are complements; that is, the farmer’s marginal product is increased when he has a tractor to use in production. As Economics 101 textbooks will tell you, in competitive markets the demand for labor reflects labor’s marginal product. Thus, as more capital is used in production, labor’s marginal product and also the demand for labor will increase, the end result being greater employment and a higher real wage for workers.

But what if technology reaches the point that the tractor can run itself? What is the need for farm workers then?

Casual observation reveals that the ratio of capital to labor employed in our economy is increasing. According to the U.S. Bureau of Labor Statistics as of the end of 2013, the labor force participation rate was 62.8% – the lowest rate recorded in the past 30 years. And even though the rate of unemployment has recently been declining, total hours of labor used in production are not going up.

In his March 16 article appearing in The Wall Street Journal, Stanford University economist Edward Lazear points out that the average hours worked per week has declined from 34.5 in September 2013 to 34.2 in February 2014. According to Lazear, the decline in the average work week implies total labor hours worked is actually decreasing.

In part the drop in hours worked and in labor force participation is a consequence of the ongoing substitution of capital equipment for labor used in production. But government policies that distort incentives are also playing a role in labor’s declining significance.

Recognizing the Role of the Federal Government

The government’s involvement in student loans provides one specific example. During the past 20 years labor force participation has decreased the most for young adults age 20 to 24. This decline has occurred at the same time as student loan debt has surged, suggesting many students are living off of loans and postponing work until after graduation.

The increase in student loans is largely a consequence of the federal government’s participation in the marketplace. The federal government offers loans at rates that are often more attractive than those available from private lenders, and with less stringent credit requirements applied to potential borrowers.

This is one example of how the government is impacting labor markets, but there are many others. The bottom line is that for a variety of reasons our economy continues to use more capital relative to labor in production.

Going for Gold

The long-term trajectory of an economy’s capital-to-labor ratio was the focus of a famous article written by Nobel-prize winning economist Robert Solow. Although written over 50 years ago, the Solow model still provides a great deal of insight into today’s economy.

Solow’s mathematical model is an abstraction of the real world, where Solow considers an economy with two factors of production: capital and labor. Within the theoretical framework, Solow demonstrates that the economy will trend towards a constant capital-to-labor ratio. An “optimal” capital-to-labor ratio occurs when the capital/labor ratio reaches a steady state that allows per capita consumption to be maximized. (This optimum is called the “Golden Rule” in the economics literature.)

So the capital/labor ratio has recently been on the increase in the United States, and indications are that it will continue to go up. How does the U.S. capital/labor ratio compare to the theoretical “Golden Rule” optimum? A look at some numbers suggests we may still have further to go in increasing capital before reaching nirvana.

The Law of Diminishing Returns

Economic theory tells us that increasing capital, while holding other factors of production constant, will have the impact of decreasing capital’s marginal product. This well-known idea is called “the law of diminishing returns.” In a competitive marketplace, capital’s marginal product is also the expected return to capital, so increasing the capital-to-labor ratio will tend to reduce the rate of return to capital ownership.

Put simply, the idea is that the returns from owning a tractor will be exceedingly high if you own the only tractor in an economy. As more and more tractors are put into operation, the returns from tractor ownership will eventually decline.

Within the framework of the Solow model, when the Golden Rule capital-to-labor ratio is realized, the annual return to capital ownership is expected to equal the growth rate in the effective labor force. That is, if labor is growing at an annual rate of 3% then the equilibrium real rate of return on capital will also be 3%.

Over the long run, the ownership of plants and equipment in the United States has provided a rate of return well in excess of the 3% growth rate in effective labor. Average real returns to a large diversified portfolio of stocks have been more in the range of 6% -7%. When compared to growth rates in labor, this high return to capital is strong evidence that more capital is needed (relative to labor) before reaching the Golden Rule equilibrium.

Tough Times Ahead for “Unskilled” Labor?

Unlike the Solow model, there is not one single type of labor in the real world; there are many. And an important distinction needs to be made between skilled and unskilled workers.

While capital equipment is taking jobs from unskilled workers, as of yet the computers cannot completely design and program themselves. Skilled workers are still needed to tell the boxes what to do. Advancing technology and more capital used in production will continue to increase the demand for software engineers and other skilled workers.

But unskilled workers could be in for tough economic times. The disparity in the income distribution will likely grow larger as the demand for unskilled labor and their real wages steadily decline.

About the author:

L. Dwayne Barney is currently a professor of finance at Boise State University, where he has taught courses in both economics and finance. His Ph.D. in economics was received from Texas A&M University in 1984. Together with Brian McGrath he is coauthor of Capital as Money, a book which argues for a new system of privately-created money.

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